Problem
Consider the following in the context of the quantity equation and the AS-AD model where the short-run supply curve is horizontal, and the long-run supply curve is vertical. Suppose that the Central Bank decides that the economy is in danger of entering a period of high inflation and that it must cut the nominal money supply by 5% to pre-empt it. Note that velocity of money is observed to be constant.
1. In percentage, what is the short-run impact on the price level?
2. In percentage, what is the long-run impact on output?
3. In percentage, what is the long-run impact on the price level?
4. Use the AD-AS model diagram to show and explain the process from initial equilibrium to the end.